Pages

Monday, May 31, 2010

More than once I've heard the advice that there is no longer any point in having a spousal RRSP because of the new pension income splitting rules. However, this is only partially true. Spousals RRSPs still make sense in some circumstances.

The origin of spousal RRSPs was a way to allow a higher income spouse to contribute to the lower income spouse's retirement savings. Basically, the lower income spouse opens a spousal RRSP, and the higher income spouse puts money in it. The amount contributed counts against the higher income spouse's RRSP contribution room and gives the higher income spouse the tax deduction.

The advantage of doing all this is to balance the incomes of the two spouses in retirement to reduce the amount of income taxes paid. However, recent tax changes allow spouses new opportunities to split pension income. In particular, anyone over the age of 65 can allocate up to 50% of a RRIF withdrawal as income for his or her spouse.

Note the restrictions here. Income splitting does not apply to RRSP withdrawals and can only be done after age 65. If you have reason to delay converting your RRSP into a RRIF past age 65, you won't be able to use income splitting on any withdrawals from the RRSP. Also, if you retire before age 65, you won't be able to split any withdrawals whether they come from your RRSP or your RRIF.

So, it can still make sense to set up and use spousal RRSPs to maintain maximum flexibility for minimizing taxes as you adapt to life changes and income tax rule changes.

Let’s look at the numbers. Suppose that Joe still primarily uses cash and makes 500 cash transactions for “random” amounts per year. This does not include any cash transactions that are designed to be for an already rounded amount.

If these random-amount transactions are paid for without any pennies, they will get between 0 and 4 pennies in change. If Joe just throws the pennies away (as I do), he loses about two pennies per transaction on average, or about $10 per year. (I actually lose much less than this because I have fewer cash transaction in a year.)

Many people may not be willing to give up $10 per year even if it means not having to deal with pennies. However, let’s see how things change if the final amounts are rounded to the nearest nickel. On each transaction, Jim will be ahead one or two cents, down one or two cents, or even. Using some statistics, we can calculate that over the course of one year, there is a 99% chance that Jim will be up or down 81 cents or less.

If we eliminate nickels and dimes as well, there is a 99% chance that Jim will be up or down by $4.14 or less in one year. I’d be happy to get rid of all these coins for such a small amount of money, especially considering that the “error” amount is unlikely to be as high as $4.14 and could be a gain rather than a loss.

It’s possible that retailers could choose prices that always cause the final price to be rounded up after the taxes are calculated, but this would be easy to detect and would lead to bad press for the company.

Maybe if these politicians were to debate eliminating nickels and dimes as well, they could decide to eliminate just the penny as a compromise.

Thanks to a friend who I assume would prefer to remain anonymous for pointing me to the Globe and Mail article.

Wednesday, May 26, 2010

Stock options have a very poor reputation. They are thought to be either the magical lottery tickets that make CEOs even wealthier or as financial dynamite that can wipe out the savings of the little-guy investor in no time.

Blogger Mark Wolfinger believes that stock options are misunderstood. He points to the many ways that options can be used to reduce the riskiness of investments. Wolfinger has devoted much effort to educating people about the smart ways to use options.

Perhaps a different approach would have a better chance of success because stock options are likely to continue to be viewed as the toys of reckless traders. The problem is that there is a steady stream of people who do manage to lose their savings by trading options. They do this by taking wild chances that Wolfinger counsels against, but that is a subtle point in the battle over the reputation of stock options. The fact is that these bad experiences lead directly to the fear of stock options.

I haven't met many people in person who told me that they have traded options, but almost all of them have stopped because they lost too much money. I can only think of one investor who I've met in person who uses stock options and is happy with the results.

My suggestion is for Wolfinger and others involved in this battle to coin some new term to cover the range of option trading strategies that they consider sensible. This way they can use this new term instead of calling themselves options traders and be perceived as reckless.

For this to work they need a good new term, they need to make it well known, and they need to prevent options gamblers from describing themselves with this new term. The last part may be the trickiest. Perhaps some term that would turn off a gambler-type personality would work best ("granny-trading"?).

If a particular approach to option trading were to gain a small amount of respectability, more commentators might be willing to give this approach to investing a full hearing. Personally, I haven't spent much time trying to learn options strategies. I can assess risk reasonably well, but I haven't figured out yet how to use options without getting eaten alive by commissions and trading spreads.

If the new term catches on, it might even make sense for brokerages to offer accounts that permit options trading that is limited to some well-defined safe strategies rather than permitting the taking of wild chances.

Tuesday, May 25, 2010

Despite the efforts of a growing number of people who advocate a passive approach to investing, the bulk of investing commentary is focused on active trading. Will the problems in Greece cause North American stocks to rise or fall? Will the rising US debt start to drive up interest rates?

I don’t know the answers to these questions, and based on the track record of various commentators, it seems that they don’t know either. So why do they persist in making short-term predictions? The answer is that this is much easier than coming up with something fresh to say about passive investing. We can always come up with something to say about the effect of some recent event on financial markets, even if the commentary is useless gibberish.

Does this mean that we should ignore all commentary about the immediate future of financial markets? Well, ignoring all of it isn’t a bad approach. I do listen sometimes, but I tend to be very critical. I won’t believe anything just because it sounds plausible. I look for certain specific things as a signal that the commentary may be worth considering.

The main things I look for are long-term evidence along with a plausible explanation for the long-term trend. You may ask how can there be long term evidence for short-term predictions. I think this is best illustrated with some examples:

1. “With interest rates so low, they are bound to rise. When they rise, stocks will get hammered. It’s time to get out of stocks.”

To evaluate this advice, let’s break it down. Over the long term (say 50 years or more), when interest rates have been at current levels, how have stocks performed over the next year? Since I just made up the quote above, I don’t know the answer, but I just assume the quote is useless until I see the evidence. Even then, the evidence may not be statistically significant. I would then want some plausible explanation of why this trend would persist even in the face of all professional traders knowing about the trend. This is a tough test.

Let’s try one that I do believe:

2. “On average, stocks have outperformed bonds for a very long time and there is good reason to believe that this will persist because investors demand a risk premium.”

This statement satisfies my test. It points to long-term evidence and explains why the situation is likely to persist even though everyone knows about it.

The implication seems to be that companies whose stock has gone down recently and who are in trouble with the law and are in legal fights with competitors are bad investments. Until someone does a long-term study, I’m sceptical. Further, if this trend exists, is there any reason to think it will continue once the investment community learns about it?

Keep in mind that Cramer may very well be right about the short-term prospects for this stock. However, I’m looking for evidence of why he should be right. Without this evidence, I’m assuming the odds are close to 50/50 and I’ll ignore Cramer.

In summary, I look for two things:

1. Long-term evidence that a particular type of investment analysis works.
2. A plausible explanation of why the analysis should continue to work even when the investment community knows about it.

Thursday, May 20, 2010

There is a particular type of advertising that tricks me almost every time. The general idea is as follows:

Buy 1 at the regular price and get a second one at

50% OFF!

I’m getting better at spotting this but invariably I see the “50% off” part and don’t notice the fine print right away. An equivalent way of saying this is that you’re getting 25% off but you have to buy two items. This doesn’t sounds as good, though.

The few times that I didn’t figure out that I wasn’t really getting 50% off before attempting to pay, I was left with a bad feeling about the whole transaction. Do businesses really get much benefit from this trickery if it leaves customers annoyed and feeling a little foolish?

Wednesday, May 19, 2010

Globe Investor is running a poll of the top Canadian blogs in two categories:

– Personal Finance
– Investing

I’m pleased to note that Michael James on Money is included in the personal finance category. There are some great blogs in this list. A noticeable omission is Canadian Capitalist, but that’s because he is one of the panellists who chose the lists.

I won’t ask my readers to head over to the poll and vote for this blog because they may have more important things to do such as running out of a burning building. However, I do encourage readers to choose their favourites from the list. Good writers need some encouragement to keep writing.

Tuesday, May 18, 2010

After a recent job change, I get new pay slips that contain cryptic entries about pay deductions. One of these entries is related to life insurance even though my employer gives me this insurance for free. Unfortunately, life insurance is considered a taxable benefit and I pay almost as much in income taxes as it would cost to buy the insurance on my own. For younger employees (like I was the last time I looked at this issue), free life insurance can be more expensive than buying it on your own.

In most group plans, life insurance premiums are based on the amount of insurance, but not the insured’s age. The plan assumes some average premium reflecting the age distribution of employees. This means that young people have an artificially high value assigned to their taxable life insurance benefit.

Employees end up paying tax on this benefit at their marginal tax rates. For young employees, this can mean paying more for the insurance than it would cost them to purchase it privately from an insurance company.

However, I’m not that young any more. Even so, the value assigned to my life insurance is more than double what I would pay privately. After factoring in my marginal tax rate, the amount I pay in taxes is only $1.47 per year less than I would pay with a private plan. So much for free life insurance.

Once you take into account the fact that this insurance would go away if I leave my employer, I’d be better off buying my own life insurance. Life insurance through group plans is usually transferrable, but the new premium goes way up unless you agree to a health check. However, if you leave your job for health reasons, this won’t help much.

Monday, May 17, 2010

I missed all of the excitement of the sudden stock market drop on May 6th. After digesting the events that evening, my thoughts were that it shouldn’t have hurt long-term investors who missed the whole thing. Prices went down, and if there was no good reason for it then prices should rebound. However, some investors were hurt even though they took no explicit action.

Stock market prices are an estimate of the actual value of real business assets. Many people see the stock market as some kind of casino, but over the long run stock prices reflect business value and not just the roll of the dice. This means that if the big price drop May 6th was just some trading glitch without any connection to business value, prices should rise back up again.

As a long-term investor, the whole thing was a big yawn. However, this is only because I avoid things that can cause automatic trading of my holdings. Investors need to make their own choices, but they should understand the risks they take. Here are a few things I prefer to avoid to maintain control over trading of my portfolio:

Stop-Loss Orders

Some investors like to set stop-loss orders that cause shares to be sold automatically if they drop to a certain price. The idea is to limit the potential loss. However, a big downward spike in prices followed by a sharp return can trigger a sale. Worse still, the sale may take place at a much lower price than expected if the shares couldn’t be sold at the stop-loss trigger point due to high volatility.

Investors can avoid a stop-loss sale taking place at a very low price using a stop-limit order. When the shares reach the stop price, a stop-limit order then triggers a limit order, but this defeats the usual purpose of the stop-loss. If the shares drive down through the stop-loss price and below the limit price as well, then the trade will not take place. This is good if the price ultimately rebounds, but bad if it doesn’t and the investor needed to avoid a big loss.

Margin

Margin means using borrowed money to buy equities. Brokerages follow rules to limit the amount of margin an investor can use. If equity prices drop to the point where the margin rules are broken, the brokerage begins selling the investor’s shares until the margin rules are satisfied once again. The May 6th stock market drop triggered some margin calls and some automatic trading. The rebound in stock prices didn’t help much for those whose shares were sold.

Authorizing a Trading Agent

A trading agent is someone you authorize to make trades in your account. I don’t mind listening to other people’s advice, but I prefer to control the final decision to take action.

I won’t say that stop-loss orders, using margin, and authorizing trading agents are always a bad idea. I just prefer to avoid them partly because I want to maintain more control over my portfolio.

4. Rachelle at Million Dollar Journey gave some useful advice on the art of tenant selection. This sparked some debates including whether potential tenants should give their social insurance numbers to landlords.

Thursday, May 13, 2010

For investors who maintain constant portfolio allocations to different asset classes, such as stocks and bonds, there is a debate about when to rebalance. Most advice is to rebalance periodically, such as quarterly or yearly. Others suggest a threshold approach where rebalancing is based on when the allocation gets sufficiently far from the target allocation. I am in this latter camp.

The idea behind periodic rebalancing is to have a defined time to look at your portfolio, sell some of the assets that have grown beyond their target percentage, and buy the ones that are below. With the threshold approach, we wait for assets to get a certain percentage away from the target percentage and then rebalance. This could take just hours or it could take years.

Here is a simple example. Sally has her retirement savings equally split between a stock ETF and a bond ETF. (In my case it would be two different stock ETFs because I prefer not to own bonds for the long term.) Over time, the ETFs will rise and fall in value and throw her 50/50 allocation out of whack. Sally could ignore her portfolio until the first trading day each quarter to rebalance. If stocks are up, she would sell some stock ETF shares and buy some bond ETF shares to restore balance.

Another approach would be to set a window of say 45% to 55% and if the allocation gets outside of these thresholds, then rebalance. With either approach there are more choices to make. With periodic rebalancing you have to decide how often, and with threshold rebalancing you have to decide how wide to make the window.

I prefer to rebalance based on thresholds because the profitability of rebalancing depends mainly on how far out of balance the allocation becomes. A criticism of this approach is that it can lead to too much trading during volatile periods, but I'm not concerned with this if the trades themselves are profitable.

Profitability of rebalancing is best illustrated with an example. I'll cook the numbers a little so that we don't have to deal with fractions. Suppose that the stock and bond ETFs are currently trading at $55 each, and Sally owns 990 units of each. Let's assume that over a period of time the bond ETF stays flat at $55, but the stock ETF drops to $45 and then returns to $55. With a 45/55 threshold, this would trigger Sally to do some rebalancing:

If Sally had done nothing over this period of time, her return would have been exactly zero. By rebalancing, she ended up with an extra 10 shares of each ETF, a gain of $1100 less costs. She made 4 trades and traded a total of 400 shares. Assuming commissions of $10 per trade and losses of one cent per share in bid-ask spreads, Sally's costs are $44 for a total profit of $1056.

Other things that can affect the profitability of rebalancing are capital gains taxes for non-registered accounts and currency conversions if the ETFs are traded in different currencies.

It doesn't matter how long it takes for stocks to drop and rise back up again; these trades profit over the "do nothing" strategy whether they take place over hours or years. This is the reason why I prefer threshold-based rebalancing rather than doing it periodically.

To set thresholds wide enough to create profits after trading costs, it's important to take into account all costs. Capital gains taxes and currency conversion costs can make a big difference. Another thing to consider in very volatile times is that bid-ask spreads can widen dramatically and significant price changes can take place between selling the overweight holding and buying the underweight holding.

In practical terms, by choosing appropriate thresholds, trading will be infrequent. However, I prefer to be ready to pounce if volatility takes my allocation outside the thresholds rather than to miss out by waiting until the next planned rebalance day.

An advantage of periodic rebalancing is that you can ignore your portfolio for months at a time. A possible compromise is to check thresholds perhaps weekly. If price changes don’t last at least a week, conditions may be too volatile to trade at predictable prices. Personally, I tend to check roughly 2 or 3 times per week using rules coded in a spreadsheet.

Wednesday, May 12, 2010

The subject of funerals isn’t much fun, but it can be a big expense. I’ve only had to be one of the primary people arranging a funeral once, and I definitely didn’t make smart choices. I was so overwhelmed by the whole process that I just agreed to pay whatever amount was asked for. However, cheaper alternatives exist.

A piece on CBC radio a week or so ago about funerals explained that the typical funeral costs between $5000 and $7000 before paying for the casket, organist, and various other extras. The total cost can easily approach $10,000. I definitely don’t want my family to waste this much money on my funeral.

An interesting alternative to a funeral home for Ontario residents is a business called Basic Cremations. (I have no connection to this business, financial or otherwise.) They will pick up the body, cremate it, and handle some basic paperwork for about $1600. They offer various other more expensive options, but this is the price of the basic cremation service.

This seems much more practical than forking over many thousands of dollars to a funeral home. The missing element is a place for a visitation. I’ve always felt that a visitation at the home of the family or a friend is more personal than a funeral home. In many cases, a subset of mourners plan to head over to a family member’s home after the funeral home visitation anyway.

Tuesday, May 11, 2010

The prospect of doing battle with the Canada Revenue Agency (CRA) over a tax dispute is daunting. Often the taxpayer is under financial pressure, and trying to pay for lawyers in a fight with an organization with near limitless resources is a definite case of David vs. Goliath.

A potential ally in a battle with CRA is the Taxpayer’s Ombudsman who upholds the taxpayer’s eight service rights:

– the right to be treated professionally, courteously, and fairly;
– the right to complete, accurate, clear, and timely information from the CRA;
– the right to lodge a service complaint and to be provided with an explanation of the CRA findings;
– the right to have the costs of compliance taken into account when tax legislation is administered;
– the right to expect the CRA to be accountable;
– the right to expect the CRA to publish service standards and report annually;
– the right to expect the CRA to warn you about questionable tax schemes in a timely manner; and
– the right to be represented by a person of your choice.

I’d like to hear from any readers who have tried to get help from the Taxpayer’s Ombudsman. Did you get your tax problem resolved in a timely and fair way?

Monday, May 10, 2010

A while back I replaced a hot water heater that had sprung a leak. In my financial analysis of whether to rent or buy a new hot water heater I didn’t take into account the fact that Direct Energy would just keep charging me for the old hot water heater I returned.

I have a nice receipt showing that I returned the old water heater on March 15, but the latest gas bill from Enbridge still has a rental charge of $15.21 (with GST) from Direct Energy. I’d like to refuse to pay, but Enbridge is the enforcer here. They can cut off my gas if I don’t pay whatever amount Direct Energy asks for.

We haven’t been sitting on our hands just hoping that the billing works out. When the previous gas bill had a full rental charge, my wife called Direct Energy. Their records indicated that the heater had been returned March 17 (off by two days but close enough). Everything seemed to be in order. We had to pay in full for the partial month, but there would be no further charges.

She called again when the most recent gas bill had another rental charge. This time the records supposedly indicated that the heater had been returned late April. At this point my wife saw a potential pattern of advancing the heater return date each month and charging us indefinitely.

So my wife tried to explain what she had been told on her last call to Direct Energy. The response from Jannita (spelling confirmed) was “well, you didn’t talk to me.” Apparently whenever you call Direct Energy to resolve some matter, you have to ask for Jannita or else you deserve whatever you get.

This call ended with a promise that the next bill wouldn’t have a charge and the bill after that would have a credit for the extra month charged. On a later call to Enbridge, my wife learned that Enbridge has a record of the heater being returned in late April. So, there is some hope.

Adding to the frustration of this nonsense was the marketing calls from Direct Energy after we returned the heater. Apparently, because we are such good customers we have the privilege of getting a new water heater and paying a lot more each month to rent it. What a deal!

We received two such calls from Direct Energy (and some paper mail with a similar offer). In both cases the caller insisted that their records indicated that we still rented from Direct Energy. In addition we had a competitor of Direct Energy come to our door “to check on our water heater’s efficiency” and try to trick us into switching suppliers. No doubt these sleazy competitors were the reason for Direct Energy’s marketing efforts. The calls probably had nothing to do with us having returned the rented heater.

In the end I’m hopeful that we won’t be charged any further, but I’m not holding my breath waiting for the promised credit.

Thursday, May 6, 2010

The MER on many of the popular iShares exchange-traded funds (ETFs) will be going up due to a 5% increase in management fees. This change will affect 29 ETFs. A notable ETF not affected by this change is the S&P/TSX 60 Index Fund (XIU).

The Notice to unitholders goes to a lot of trouble to explain that this is just a change in the way that the GST is handled. BlackRock used to pay the GST out of the management fees collected, but now they won’t. The claim is that “There will be no change to the amount of management fees paid by any iShares Fund.”

Notwithstanding language games, the amount of management fee kept by BlackRock for the affected funds will be going up by 5%. The amount that investors will pay for the combination of management fees and GST will be going up by 5%. There is no getting around the fact that this is a 5% fee increase.

Wednesday, May 5, 2010

I am a long-time user of QuickTax, but I’ve always used the desktop version. From a recent entry on Ellen Roseman’s blog, I learned that the online version of QuickTax does not give direct access to the tax forms; you must use the interview method. The desktop version gives access to both forms and the interview process.

I find the “easy step” interview process quite convenient to use, but I’ve never been able to use it exclusively. I’ve always had to go directly to the tax forms to enter data the interview process missed or to check that I did things correctly or optimally. It may be that I don’t quite use the interview process correctly, but the reason why certain things get missed doesn’t matter. The end result is that I need access to the forms.

I’m interested in the experience of other users now that we’re through tax season. Are you able to use the interview process exclusively or do you need to access the forms? Not having the forms accessible is a show-stopper for me, but perhaps my needs are atypical.

Tuesday, May 4, 2010

For the past 10 or 11 weeks it seems like Canadian and US stocks have gone up every day. There have been a few down days, but the rise has been quite steady. Even though I know better, I expect to see another increase when checking each day.

If this trend continues long enough, many investors scared off by the market lows from a little over a year ago will be lured back in. Even higher stock prices would lure in people who have never invested in stocks before.

Few of us are immune to the perverse tendency to be wary when stock prices are low and confident when they are high. Perhaps we can expect the deluge of reports about reducing risk by reducing stock ownership to reverse and we’ll see more commentators talking about the merits of long-term stock ownership.

I find I can never remind myself too often about Warren Buffett’s advice to “be fearful when others are greedy and greedy when others are fearful.” So, instead of going out and spending as though you expect stocks to continue their steady climb, make plans that include the possibility of another big drop in stock prices.

This brings me to the question of how reasonable CRA plans to be about this. I’m in a situation where I owe a very large sum under the current tax rules, but once the budget becomes law, I can refile my 2009 taxes to owe a much smaller sum. As the transition of the budget into law is largely a formality, it makes little sense to send CRA a lot of money only to get it back soon.

After penetrating many levels into CRA’s help system, I was told that in fact I could just pay the lesser amount and my return would be held until the budget passes (as long as I file the return along with some special forms to ask for special treatment). This sounds very reasonable, but I have no assurance that things will actually work this way. It will be interesting to see whether my return will in fact be held or whether CRA’s collection system will be aimed at me.

There are many people in the same situation I’m in. I won’t be surprised if some have their returns held and others don’t. I’m hoping I’m part of the lucky group.